Chapter Outline

• Income Statement
Review of
Chapter Accounting
• Price-earnings Ratio

2
• Balance Sheet
• Statement of Cash Flows
• Tax-free Investments (Depreciation)

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 2-2

Basic Financial Statements Income Statement

• Income Statement • Device to measure the profitability of a firm
• Statement of Retained Earnings (a short over a period of time
supplement to the income statement) – It covers a defined period of time
• Balance Sheet – It is presented in a stair-step or progressive
fashion to examine profit or loss after each
• Statement of Cash Flows type of expense item is deducted

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 Income Statement (cont’d) Income Statement (cont’d)
Table 2–1
Sales – Cost of Goods Sold (COGS)
= Gross Profit (GP)

GP – Expenses = Earnings Before Interest and

Taxes (EBIT) or Operating Income (OI)

EBIT – Interest = Earnings Before Taxes (EBT)

EBT – Taxes = Earnings After Taxes (EAT) or Net

Income (NI)
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Return to Capital Statement of Retained Earnings

• Three primary sources of capital: • Indicates disposition of earnings with:
– Bondholders (receive interest) – any adjustments to previously reported income
– Preferred stockholders (receive dividends) – any restrictions on cash dividends
– Common stockholders (receive dividends after
preferred stockholders)
• Earnings per share
– Interpreted in terms of number of outstanding
shares
– May be paid out in dividends or retained by
company for subsequent reinvestment 2-7 2-8

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 Price-Earnings (P/E) Ratio
• Multiplier applied to earnings per share to
determine current value of common stock
• Indicates expectations about the future of a
company
• Some factors that influence P/E:
– Earnings and sales growth of the firm
– Risk (volatility in performance)
– Debt-equity structure of the firm
– Dividend payment policy
– Quality of management
2-9
Price-earnings Ratios
for Selected U.S. Companies
• Expectations of returns and P/E ratios do
change over time
2-11
Price-Earnings (P/E) Ratio (cont’d)
• Allows comparison of the relative market
value of many companies
• Firms with higher expected returns will
have higher P/E ratio
• Price-earnings ratios can be confusing
– Drop in earnings may not match the magnitude
of the falloff in earnings, which causes
increase in P/E ratio
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Limitations of the Income
Statement
• Income gained/lost during a given period is
a function of verifiable transactions
– Stockholders, hence, may perceive only a
much smaller gain/loss from actual day-to-day
operations
• Flexibility in reporting transactions might
result in differing measurements of income
gained from similar events at the end of a
time period
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 Balance Sheet Balance Sheet Items
• Indicates what the firm owns and how • Liquidity: Asset accounts are listed in order
these assets are financed in the form of of liquidity
– Current assets
liabilities or ownership interest • Items that can be converted to cash within one year
– Delineates the firm’s holdings and obligations – Marketable securities
– A picture of the firm at a point in time • Temporary investments of excess cash
– Accounts receivable
– Items are stated on an original cost basis • Allowance for bad debts to determine their
rather than at current market value anticipated collection value
– Inventory
• Includes raw materials, goods in progress, or
finished goods
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Balance Sheet Items (cont’d) Balance Sheet Items (cont’d)

– Prepaid expenses – Total assets: Financed through liabilities or
• Represent future expense items that are already paid stockholders’ equity
for • Liabilities are financial obligations of the firm and
– Investments move from current liabilities (due within one year)
• Long-term commitment of funds (at least one year) to longer-term obligations
• Includes stocks, bonds, or investments in other
corporations • Short-term obligations
– Plant and equipment – Accounts payable (amount owed on open account to
suppliers)
• Carried at original cost minus accumulated
depreciation – Notes payable (short-term signed obligations
– to the banker or other creditors)
• Accumulated depreciation: Sum of past and present
depreciation charges on currently owned assets – Accrued expense (payment not made for the obligation
incurred on the services received)
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 Statement of Financial Position
Stockholder’s Equity
(Balance Sheet)
• Represents total contribution and
ownership interest of preferred and
common stockholders
– Preferred stock
– Common stock
– Capital paid in excess of par
– Retained earnings

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Concept of Net Worth Limitations of the Balance Sheet

Net worth/book value = Stockholders’ equity • Most of the values are based on
– preferred stock component historical/original cost price
• Market value is of primary concern to the: – Troublesome when it comes to plant and
– Financial manager equipment and inventory
– Security analyst • FASB ruling on disclosure of inflation
– Stockholders adjustments no longer in force
– It is purely a voluntary act on the part of the
company

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 Limitations of the Balance Sheet Comparison of Market Value
(cont’d) to Book Value per Share
• Differences between per share values may
be due to:
– Asset valuation
– Industry outlook
– Growth prospects
– Quality of management
– Risk-return expectations

2-21 2-22

Statement of Cash Flows Statement of Cash Flows (cont’d)

• Emphasizes critical nature of cash flow to
the operations of the firm
– It represents cash/cash equivalents items
easily convertible to cash within 90 days
• Advantage of accrual method
– Allows matching of revenues and expenses in
the period in which they occur to appropriately
measure profits
• Disadvantage of accrual method
– Adequate attention not directed to actual cash
flow position of firm
• Cash flow analysis helps in combating
discrepancies faced through accrual
method of accounting

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 Sections of a Statement of Cash Concepts Behind the Statement of
Flows Cash Flows
• Three primary sections of the statement of
cash flows:
– Cash flows from operating activities
– Cash flows from investing activities
– Cash flows from financing activities
• The results of three sections are added
together to compute the net increase or
decrease in cash flow

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Determining Cash Flows from Net Cash Flows from

Operating Activities Operating Activities (Indirect Method)
• Translation of income from operations from
an accrual to a cash basis
• Direct method
– Every item on the income statement is
adjusted from accrual to cash accounting
• Indirect method
– Net income represents the starting point
– Required adjustments are made to convert net
income to cash flows from operations
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 Cash Flows from Operating
Comparative Balance Sheets
Activities
Table 2–6

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Determining Cash Flows from Determining Cash Flows from

Investing Activities Financing Activities
• Investing activities: • Financial activities apply to the
– Long-term investment activities in mainly plant sale/retirement of:
and equipment – Bonds
• Increasing investments represent a use of funds – Common stock
• Decreasing investments represent a source of funds – Preferred stock
– Other corporate securities
– Payment of cash dividends
• Sale of firm’s securities is a source of funds
• Payment of dividends and repurchase of
securities is a use of funds
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 Overall Statement
Analysis of the Overall Statement
Combining the Three Sections
• How are increases in current assets being
financed?
• Is there an associated buildup in current
liabilities?
• How are increases in long-term assets being
financed?
• Preferably, adequate long-term financing and
profits should exist to finance long-term assets
• Short-term funds may be used to carry long-term
needs – could be a potential high-risk situation as
short-term sources of funds may dry up while
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long-term needs continue to demand funding 2-34

Comparison of Accounting
Depreciation and Funds Flow
and Cash Flows
• Depreciation
– A noncash expense
– Not a ‘new’ source of funds
– Added back to net income to determine
amount of actual funds on hand
– Attempt to allocate the initial cost of an asset
over its useful life
• Charging of depreciation does not directly
influence the movement of funds
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 Free Cash Flow Income Tax Considerations
Free Cash Flow = Cash flow from operating • Corporate tax rates
activities – Capital expenditures – Dividends – Progressive: the top rate is 40% including
state and foreign taxes if applicable. The lower
– Capital expenditures bracket is 15–20%
• Maintain productive capacity of firm • Cost of a tax-deductible expense - Interest,
– Dividends Travel expenditures, Salaries, etc.
• Maintain necessary payout on common stock and to Corporation A Corporation B
cover any preferred stock obligations Earnings before interest and taxes………….
Interest……………………………………………
$400,000
100,000
$400,000
0

• Free cash flow is used for special financing _________ _________

Earnings before taxes (taxable income)…… 300,000 400,000

activities Taxes (40%)……………………………………… 120,000
_________
160,000
_________
– Example: leveraged buyouts Earnings after taxes……………………………
Difference in earnings after taxes……………
$180,000
$60,000
$240,000

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Depreciation as a Tax Shield

Chapter Two
• Not a new source of fund
• Provides tax shield benefits measurable as
depreciation times the tax rate
Corporation A Corporation B
Earnings before depreciation and taxes…… $400,000 $400,000
Depreciation……………………………………… 100,000
_________
0
_________ The End
Earnings before taxes………………………… 300,000 400,000
Taxes (40%)……………………………………… 120,000 160,000
_________ _________
Earnings after taxes…………………………… 180,000 240,000
+Depreciation charged without cash outlay… 100,000 0
_________ _________
Cash flow………………………………………… $280,000 $240,000
Difference………………………………………… $40,000
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